Hedge Fund Redemptions and Volatility

Investors in some funds probably want their money back, which could lead to forced selling.

Investors trying to divine the near-term future of energy stocks should consider a factor that doesn't show up in sector fundamentals: bad hedge fund returns.

The problem is redemptions, which occur when a fund's returns are weak enough that investors ask for their money back. After a grim October, it's a safe bet that redemption requests are rolling in at some shops, especially since many funds require up to 45 days' notice before paying money out. An investor hoping to collect before year's end has only a few days left.

The need to raise cash could add to the market's volatility, particularly in popular sectors.

"Most people were long energy and short retail," said says Rick Doucette, chief investment officer at George Weiss International, a Hartford, Ct.-based fund. "If you're long energy and you see a drop of 10% in that position, as a hedge fund, you need to book your profits for the year and so you sell."

While fundamental factors like lower oil prices clearly drive the space, it's possible that the unwinding of the energy/retail trade has contributed to the roughly 4% decline in the Amex Oil Index over the past five sessions, a period that has corresponded with a 3% firming in the S&P Retail Index.

"If you look at how energy has performed relative to all sectors, it's been by far the best of the year, so managers are likely to take some profits off the table," says Kevin Campbell, vice president of research at Van Hedge Fund Advisors International, a research-focused hedge fund advisory firm.

Most hedge funds have been hurt in October, with the bulk of the pain in strategies that focus on merger arbitrage and big corporate news events. "I don't know of any arb that wasn't down," says Nancy Havens, founder of Havens Advisors, a New York-based merger arbitrage hedge fund. She cites the failed Guidant ( GDT), Cablevision ( CVC) and School Specialty ( SCHS) deals as the leading causes of performance (although she stresses that her fund isn't anticipating outflows).